2011 Bankruptcy Review: What Comes Down Must Go Up

Approximately five years after the United States economy took a nosedive, analysts have started to note possible signs of an economic turnaround. Unemployment claims are at their lowest level since 2008. U.S. GDP is in its tenth consecutive growth quarter. American retail spending is increasing. Additionally, President Obama stated his confidence in continuing economic growth. However, where does the fact that 2011 business and consumer bankruptcy filings were down (as compared to 2010) fall? Whether it is another encouraging signal that the bad economy is on its way out or simply has no correlation, bankruptcy filings this past year have fallen across the board.

Consumer Bankruptcy

Personal bankruptcy filings fell 12% in 2011, with only one out of every 175 Americans filing, compared to one out of 150 people in 2010. Coming off the heels of a steady rise in personal bankruptcy filings from 2005-2010, the American Bankruptcy Institute (ABI) had expected that trend to continue into 2011. The rise in filings during this period came despite the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act, which placed more restrictions on filing debtors. The ABI stated that the steady increase in filings was a result of high debt burdens along with stagnant income growth.

After the first six-months of 2011, the ABI credited the drop in bankruptcies to “continued efforts of consumers to reduce their household debt and [the] overall pull back in consumer credit.” However, the months preceding June 2011 showed growth before consumer spending declined, even then only 0.2%.The analyst associated with the growth study reasoned the decreased spending was the result of unemployment, stagnant wages, and fuel costs. As a result, the reasons given by the ABI for the increase in filings from 2005 to 2010 do not match up with the realities of a decrease in filings during 2011.

Though the economics of consumer debt and bankruptcy filings is complex (with experts voicing their dueling opinions over the matter) possible explanations exist for the 2011 bankruptcy filing decline. First, in the wake of lending disasters of the recent past, perhaps banks and lending institutions have been more stringent about consumer debt borrowing.1 With less debt available to them, there are presumably fewer chances for consumers to default on loans, resulting in fewer bankruptcies. Second, the real estate market has been in a severe decline since 2006. The beginning of this decline was right before the real estate bubble popped and home mortgage lending was at its peak. Therefore, it is possible that banks holding onto non-performing or under performing mortgages do not have an interest in foreclosing on homes whose value far under secures their loan. Rather, these banks may be holding onto these mortgages to give the real estate market time to rebound, thus securing a higher return upon foreclosure at a later date.

Business Bankruptcy

The 12% decline in consumer bankruptcy filings this past year parallels the 14% decline in business bankruptcy filings (by a corporation, partnership, or an individual with debts predominately related to operation of business) for the same period. Even more impressive, publicly traded companies filed 86 times in 2011, compared to 106 filings in 2010, and 211 filings in 2009. Though down in number, the 2011 business bankruptcies eclipsed 2010 bankruptcies in pre-petition assets: $1.2 billion, compared to $840 million in 2010. While there were fewer bankruptcy filings, the increase in pre-petition assets involved means that the size of the bankruptcies, the value of them, actually grew approximately 70% in 2011.2 Notably, there were several high-profile bankruptcies filed in 2011 including AMR Corporation (American Airlines), MF Global Holdings Ltd., Borders and Dynegy Holdings.

In 2011, a total of four financial-institution bankruptcies occurred (compared to ten in 2010). Furthermore, bank failings (receiverships handled by the Federal Deposit Insurance Corporation, a separate process than bankruptcy) in 2011 rested at 92, a significant reduction from 2010’s 161. However, the relative health of financial institutions as a whole could have been caused by tighter consumer lending (mentioned above).

The decline in business bankruptcies might be related to the rise in out-of-court restructuring. Similar to consumer mortgages and loans, banks might be holding onto non-performing or under-performing business loans and favoring leniency and extended timeframes for defaults. This strategy allows banks to avoid dealing with the automatic stay of a debtor’s assets, the attorneys’ fees, and the multi-creditor concessions that accompany chapter 11 reorganizations. Another explanation for this decrease is that the balloon loans issued pre-2008 have not yet become due. This means that 2012 could have a significant increase in bankruptcy filings.

However, businesses that file for reorganization under chapter 11 do not always file due to insolvency, or even high levels of financial distress. Donald Trump, whose companies have filed for chapter 11 on four separate occasions, stated “I’ve used the laws of this country to pare debt. We’ll have the company. We’ll throw it into a chapter. We’ll negotiate with the banks. We’ll make a fantastic deal. You know, it’s like on ‘The Apprentice.’ It’s not personal. It’s just business.” This type of attitude may stem from the reality that companies who owe banks a lot of money are more likely to strike a deal with that bank. This allows these companies to reorganize. They receive post-petition lending and usually only need to acquiesce to a bankruptcy plan that pays well under what banks are owed. A bank is incentivized to agree to this type of out-of-court restructuring plan because it might want to preserve a business relationship with a promising businessman (like Trump). Another reason a bank may agree to such a plan is that keeping the debtor afloat may be the best way to get repayment. Either way, the attitude suggested by banks might indicate that the possible uptick in out-of-court reorganizations kept 2011 bankruptcies at bay.

What to Expect in 2012

Predicting a bankruptcy wave is a tough task. Several different factors come into play: the amount of money banks and other financial institutions are willing to lend financially distressed companies, the possibility of the economy landing in a double-dip recession, and the possible implications of the European debt crisis. While all these indicators are imprecise, the surge in filings during the last quarter of 2011 might serve as an excellent forecast for what is ahead in 2012.

The United States’ weak economy, feeble consumer spending, shaky junk-bond market, and increasingly tight lending practices may continue to threaten struggling companies into 2012. Lawyers are preparing for a big increase in bankruptcy work.3Jay Goffman, co-head of the Global Restructuring Group at Skadden, Arps, Slate, Meagher & Flom said “it’s getting busier for everyone I know. I think 2012 will be a busy year and 2013 and 2014 will be extraordinarily busy years in restructuring.”

For a successful restructuring, it is key that consumers have confidence in the economy and companies have easy access to lending. If consumers continue to stay frugal–keeping debt down and spending modestly—and financial institutions lend (appropriate) funds to restructuring companies, the 2011 trend of decreasing bankruptcies might just continue. If continued, the trend would allow consumers to fly on American Airlines to LAX (Twinkie in hand) to catch a Dodger’s game, memorializing the event with their new Kodak camera.4

Update – 2012 So Far

After the first few months of 2012, the projections that bankruptcy filings would increase proved to be too generous. In fact, the “distressed state of the Chapter 11 industry” was discussed during the ABI’s 30th Annual Spring Meeting in late April.5 During a session titled “Is the Chapter 11 Industry Distressed?” Keith J. Shapiro, from the Chicago office of Greenberg Traurig LLP, said the people who represent distressed businesses in the future are “screwed.”6 Shapiro rationalized his statement by stating the downward trend in the duration of bankruptcy cases has affected the amount of work in the industry.7 “This industry is driven by subtle changes in credit. The worst case for us is stability, and we’re in year three of stability right now,” explained Daniel F. Dooley of MorrisAnderson in Chicago.8Explained differently, the extended low interest rate environment, which allows over-leveraged companies to refinance and delay a bankruptcy filing (at least in the short-term), keeps corporate bankruptcy filings declining.

Despite industry professionals’ grim outlook on the future of chapter 11 work, out of court alternatives to bankruptcy, like receiverships, assignments for the benefit of creditors, foreclosures and out of court workouts, were noted during the session as increasing in popularity.

Data compiled by University of Illinois College of Law Professor Robert Lawless supports the concerns of bankruptcy attorneys that filings will continue to fall. After the first quarter in 2012, bankruptcy filings declined 12.8% overall as compare with this time last year. However, other sources report that the number of commercial filings for public companies in 2012 have rose, compared with 2011. Despite the doom and gloom of bankruptcy attorneys, it may be too early in the year to accurately gauge the future trends for bankruptcy filings.

1 Of course, this argument might steer the other way; if banks allow more credit to consumers, perhaps consumers could pay down prior debts with the borrowed funds (though the healthy financial sector described below supports the former suggestion).

3 Planning accordingly, 31% of lawyers said they plan to add legal jobs in the first three months of 2012, with bankruptcy among one of the strongest areas of growth. http://www.washingtonpost.com/business/capitalbusiness/lawyers-cautiously-optimistic-about-hiring-in-q1-arent-fox-adds-health-policy-adviser/2011/12/28/gIQAqwEeUP_story.html.